Why the hunt for yield is not over yet

The decline in real (after-inflation) interest rates has been a global phenomenon over the past few decades, which has progressively undercut the returns from relatively safe fixed-income investments.

In its recently released April World Economic Outlook, the International Monetary Fund noted that real global 10-year government bond yields have declined from a peak of about 6 per cent in the early 1980s to 2 per cent by the early 2000s – and effectively zero in more recent years.

In turn, falling real interest rates also sparked a global search for yield, with investors being encouraged to take on more risk – through corporate bonds, equities and property – to secure a decent return. This has led to a surge in market valuations for assets with attractive yields.

But with the global economy gradually recovering, attention is now focused on the extent to which interest rates are set to go back up in coming years – which would offer better returns on safer assets but hurt market valuations for riskier assets.

However, according to the IMF, global savings and investment trends suggest that while real interest rates are likely to rise in the medium term, “there are no compelling reasons to believe that rates will return to the levels of the early 2000s".

In short, while there may be some lift in nominal interest rates, it won’t be dramatic. And the rise in real yields will be even more modest to the extent that global inflation also lifts.

Accordingly, the search for decent yields is likely to remain an important theme in investment markets for some time. Note that medium-term trends in average real interest rates across the world are not set by central bankers or governments per se, but rather by the overall interaction of global supply and demand for funds.

Impact of cheaper technology

Related Quotes

Company Profile

According to the IMF’s research, real interest rates first began falling in the early 1980s due to a decline in the price of investment goods, as computers became cheaper and more powerful. This meant investment spending – effectively the demand for funds – as a share of global output was able to decline.

Cheaper technology also helped lower consumer inflation more broadly, which led many inflation-fighting central banks – especially the all-important United States Federal Reserve – to progressively scale back what had been exceptionally tight credit policies. Improved public savings in developed economies from the mid-1990s also reduced demand for funds, helping to lower real interest rates further.

That’s not all. According to the IMF, then came the rise in saving among emerging economies – principally China – in the decade preceding the global financial crisis, as incomes for both governments and households in these economies rose faster than their spending levels.

The fact that emerging-market savers – especially governments such as that of China – preferred the safety of developed-world bonds rather than equities added to the downward pressure on interest rates.

We might sum up all these pre-GFC forces as being positive supply shocks which helped lower real interest rates while also supporting economic growth. No wonder it was a great time for asset markets more generally.

Moreover, since the GFC the balance of saving and investment trends has helped drive yields lower, although these can be considered negative demand shocks as they tend to hurt economic growth.

That’s still good for bond values, but has had mixed implications for equity and property values.

Rise in private saving

Most obviously, investment demand in developed economies has fallen, further depressing real yields. The IMF notes the history of financial crises suggests a speedy return in investment levels is unlikely.

Of course, weaker growth also causes public saving to fall, but this has tended to be offset by a rise in private saving, as evident among developed economies in recent years.

As the IMF concludes, “the global financial crisis can be expected to leave significant scars in the medium term on investment but not on saving, which will contribute to continued low real interest rates for some time".

Adding to the downward pressure on real yields is the still exceptionally loose monetary policy in many countries, and continued heightened investor risk aversion given the volatility in investment markets over the past decade. Meanwhile, as public debt in developing countries has increased, the effect on risk premiums is likely to be offset by progressive signs of budget improvement as their economies recover.

On the upside, structurally weaker growth in emerging markets should add to upward pressure on global real yields, as it will depress global saving more than investment but not be enough to offset the other factors holding down yields.

All up, persistently weak private investment demand and budget consolidation in developed economies, together with loose monetary policy and investor risk aversion, should limit the rise in real interest rates over the next year or so.

The good news is this means the persistent search for yield should keep upward pressure on the asset values of riskier assets, such as equities and property.